Although the Bailout Bill Was Rejected, It's No Time to Panic

By Martin Hutchinson
Contributing Editor
Money Morning

Unless you’re the chairman of the George W. Bush Presidential Library hoping for one last truly memorable economic achievement that would guarantee some big donations – as well as eventual visitors – the failure of the $700 billion bailout yesterday (Monday) was no time to panic.

Of course, the stock market did panic, with the Dow Jones Industrial Average plunging more than 777 points in its worst-ever single-day point loss (although the 6.98% decline in percentage terms is much less severe than the 20% nosedives of 1987 and 1929). At this stage, however, it’s apparent that the U.S. stock market is actually catching up to a new – and more-sobering – reality that’s been apparent ever since The Bear Stearns Cos. Inc. collapse back in March: For the U.S. economy as a whole, the failure is actually good news over the long haul; it paves the way for the re-emergence of American economic might on a basis that’s far sounder than has existed since the middle 1990s.

The bailout plan was unworkable. It basically called for the U.S. taxpayer to buy “toxic waste” debt from banks that knew far more about what that debt was worth than the ultimate buyer ever would. The plan made rosy and unrealistic promises about the eventual cost to the taxpayer being zero. There were no limitations on what prices could be paid for the debt, and U.S. Treasury Secretary Henry M. “Hank” Paulson and U.S. Federal Reserve Chairman Ben S. Bernanke so committed to the scheme that the taxpayer would not have been present at the negotiating table – hence Bernanke’s outrageous comment last week that taxpayers could pay well above market prices for this rubbish was only too likely to be realized.

Participating banks were to suffer tax penalties on the remuneration of their five top officers, and would be forced to grant indeterminate amounts of warrants to the Treasury, and Congress would have the right at the end of five years to recoup the cost of the bailout from the financial-services industry. The effect of these provisions would be to remove the bailout’s activities from the normal market for these rubbish assets, preventing the alleged central objective of the plan from being realized.

The outcome would almost certainly be a more or less total loss of the $700 billion by taxpayers, while the prices of certain assets on bank balance sheets would remain completely undetermined, since there would be no proper market for them, but only a bunch of politicians playing with funny money. That reality – plus the obligation to pay back the government’s outlay for a giant mess in five years’ time – would leave huge investing risks present in all banks up to, and including, JPMorgan Chase & Co. (JPM).

The bottom line is that the U.S. government would have controlled the entire U.S. financial sector.

At this point, it sure looks as if we can thank the good sense of the U.S. House of Representatives, and hope against hope that it will adjourn for electioneering without passing this legislation – or anything else that’s anything like it.

Back in December 1929, then-U.S. Treasury Secretary Andrew W. Mellon – one of the greatest to serve in that role, and the only treasury secretary to serve under three U.S. presidents – announced that the problem of the Wall Street crash could be met by liquidation: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... purge the rottenness out of the system.”

The opposite path was taken by President Herbert Hoover with his Reconstruction Finance Corp. (RFC) – to a notably more unhappy result – just as the opposite path was chosen by Paulson and his acolytes. Borrowing $700 billion to invest in mortgage paper that has shown itself to be virtually worthless; it just reinforces failure and starves success of the capital it needs, which is the exact opposite of the recipe for success in a free market system. The great Austrian economist Joseph Schumpeter said that capitalism was a process of “creative destruction.” You cannot have the one without the other, so pouring money down a rat-hole to prevent further destruction will kill creativity and turn the economy into a Soviet-style mess.

As for the stock market, it is becoming increasingly clear that it has been suspended for the last decade at an artificially high level by the immense bubble of cheap money created by Federal Reserve chairmen Alan Greenspan and Bernanke since 1995. U.S. stocks, therefore, were poised for a drop, to an equilibrium level that could be as low as 7,500 on the Dow (I arrived at that potential nadir by measuring from early 1995, and calculating based upon a belief that stock prices should increase approximately in line with gross domestic product, or GDP), or even 5,000, should the market’s “animal spirits” find themselves to be exceptionally depressed.

Yesterday’s sharp drop could mark the beginnings of a realization by the market that the world has changed since 2006, that the subprime mortgages and securitized assets it thought so solid in 2006 were speculative toys, or outright junk, and that a world of lower asset prices can still be a world of increasing incomes and economic growth. 

Once stock prices are so low that stocks yielding 6% can be found everywhere, the U.S. middle classes will once again begin saving and investing in stocks. Only then will the U.S. payments deficit disappear (because imports will no longer be artificially inflated) and the funding problems of government will become manageable.

This will bring about other benefits. New-growth businesses in the U.S. economy will find funding from domestic savings, something that’s non-existent right now. Emerging markets will have higher costs of capital than the United States, because of their smaller capital bases in a world of scarcer money, so that outsourcing jobs and investments to them will take place only when there is a true comparative advantage in the poorer country, including proper recognition of the higher costs of capital there.

As I discussed last week, the optimal current investment strategy is a defensive one, with inverse Treasury bond funds (such as the Rydex Juno Inverse Government Long Bond Fund (RYJCX)), some gold, and maybe some other carefully chosen counter-market plays. However, the failure of the bailout package, if it persists without a “rescue,” has made the moment when optimism returns considerably closer. For that we can be thankful.

[Editor’s Note: Money Morning Contributing Editor and credit expert Shah Gilani has outlined an alternative bailout plan that is designed to ease the banking crisis at a minimum cost for U.S. taxpayers. It’s a complicated issue, no doubt. But we urge you to take a look at the "Money Morning Plan." If you believe that some (or all) of these points make sense, we urge you to pass them along to the congressional representatives and governors of your respective states – especially now that debate has taken on an emergency status and that time is of the essence. We’ve even provided a listing of each state’s representatives.]

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